horngren_fin14_F06

Horngren's Accounting Overview

• Title: Horngren's Accounting, Fourteenth Edition

• Focus: The Financial Chapters

• Chapter: 6 - Merchandise Inventory

Chapter 6 Learning Objectives

Learning Objective 6.1

• Identify accounting principles and controls related to merchandise inventory.

Learning Objective 6.2

• Account for merchandise inventory costs under a perpetual inventory system.

Learning Objective 6.3

• Compare effects on financial statements using different inventory costing methods.

Learning Objective 6.4

• Apply the lower-of-cost-or-market rule to merchandise inventory.

Learning Objective 6.5

• Measure effects of merchandise inventory errors on financial statements.

Learning Objective 6.6

• Use inventory turnover and days’ sales in inventory to evaluate business performance.

Learning Objective 6.7

• Account for merchandise inventory costs under a periodic inventory system.

Accounting Principles and Controls

Key Principles Related to Merchandise Inventory

• Consistency: Use the same accounting methods over periods to allow comparability. Changes must be disclosed in financial statement notes.

• Disclosure: Financial statements must provide enough information for external decision-making; the information must be relevant and faithfully presented.

• Materiality: Perform strict accounting only for significant items. Significant information is that which could alter decisions. Example: $10,000 may be material for a small business, but not for a large corporation.

• Conservatism: Report the least favorable financial figures when multiple options are available. This principle advises to anticipate no gains and to provide for all probable losses; assets are recorded at the lowest reasonable value.

Control Over Merchandise Inventory

• Good inventory control includes:

  • Authorizing inventory purchases properly.

  • Tracking and documenting inventory receipts.

  • Recording damaged inventory appropriately.

  • Conducting physical inventory counts annually.

  • Accurately recording and removing sold inventory.

Data Analytics in Accounting

• Importance of inventory as a major asset for merchandising and manufacturing companies:

  • Businesses utilize data analytics for inventory evaluation.

  • Examples:

    • Airbnb: Analyzes vacation habits and accommodation preferences to identify listing shortages.

    • Dickey’s Barbecue Pit: Tracks inventory in real-time every 20 minutes to manage excess and avoid spoilage.

Merchandise Inventory Costs Under Perpetual Inventory System

Cost Determination

• End of period inventory count: Count units and assign dollar amounts.

• Units sold during the period must also be accounted for.

Inventory Costing Methods Under Perpetual System

• Four allowable methods by GAAP:

  • Specific identification: Tracks specific costs for particular units (e.g., automobiles, jewels).

  • FIFO (First-In, First-Out): Assumes oldest inventory is sold first. Higher ending inventory value and lower COGS during rising prices.

  • LIFO (Last-In, First-Out): Assumes newest inventory is sold first. Lower ending inventory value and higher COGS during rising prices.

  • Weighted-average: Average cost per unit calculated continuously, affecting both ending inventory and COGS with the same cost per unit.

Comparing Effects of Different Costing Methods on Financial Statements

• Income Statement Effects:

  • LIFO results in higher COGS and lower net income compared to FIFO during periods of rising costs.

• Balance Sheet Effects:

  • FIFO inventory value is typically higher than LIFO in rising cost environments.

Lower-of-Cost-or-Market Rule

• Under this rule, inventory is reported at the lower of its historical cost or current market value. This ensures conservative valuation and helps avoid overstatement of assets.

Measuring Merchandise Inventory Errors

• Errors in inventory can cascade into related accounts (e.g., COGS, gross profit, net income).

• An overstatement in ending inventory can inflate profits.

• Inventory errors generally cancel out over two accounting periods.

Evaluating Business Performance

Inventory Turnover

• Ratio measures the speed at which inventory is sold, should be assessed against industry averages.

  • High turnover indicates effective sales; low turnover may indicate issues.

Days’ Sales in Inventory

• Measures the average number of days inventory is held, critical for perishable inventory.

Merchandise Inventory Costs Under a Periodic Inventory System

• Key differences: Inventory isn’t continuously tracked; beginning inventory balance is maintained until end of the period, when it is adjusted based on ending inventory calculations.

• COGS is computed at the end of the period using inventory accumulation.